Vanguard's Formula for Beating Mutual Fund Benchmarks

NEW YORK ( TheStreet) -- In recent years, investors have poured into Vanguard Group's index mutual funds.

Since 2008, assets in Vanguard Total Stock Market Index ( VTSAX) have more than doubled to $225 billion. At the same time, some shareholders have pulled money out of Vanguard's actively managed mutual funds.

But in most cases, the shift away from active management has been a mistake.

According to a new study by Vanguard, the company's actively managed funds have outdone the index funds. On average, a dollar put into an active fund outpaced an investment in a comparable index fund by 0.79% annually during the past 30 years.

The findings must come as a jolt to many loyal followers of Vanguard and its founder John Bogle. During his long career in the mutual fund industry, Bogle has famously championed index funds. In speeches and bestselling books, Bogle argued that most investors should favor passive choices and avoid actively managed funds.

Over the years, Vanguard has published numerous studies on the virtues of indexing. The company has frequently argued that it is difficult to predict which actively managed funds will excel in the future. Now the latest study takes a different tone, arguing that investors "can be successful using actively managed funds."

Though the active funds have excelled through much of the past three decades, the margin of outperformance was particularly large during the past 10 years.

Among the star performers was Vanguard Capital Value ( VCVLX), a large blend fund that returned 9.6% annually during the past decade, compared to a return of 8.0% for Vanguard 500 Index ( VFINX), according to Morningstar.

Vanguard does not speculate about why the company has done so well lately. But it seems clear that most of the company's funds work to control risk, a factor that helped limit losses during the financial crisis.

Make no mistake, Vanguard's endorsement of active management is lukewarm. The study notes that while the company has succeeded, most active managers from competitors have lagged the benchmarks.

Why has Vanguard excelled? The biggest single reason is low fees. Vanguard's active equity funds charge average expense ratios of 0.37%, compared to 1.29% for the average domestic equity fund.

Many researchers have shown that cheap funds outdo expensive ones. Active managers tend to lag the benchmarks because of high fees. In its study, Vanguard argues that the best single predictor of future performance is low fees.

Vanguard has long charged less because of its unique corporate structure. While nearly every competitor is a profit-making business, Vanguard is a mutual company that is owned by its shareholders. Because it does not have to achieve profits, Vanguard can impose low fees.

In its study, Vanguard argues that part of the reason for the strong performance is the way the company selects portfolio managers. While fund companies such as Fidelity and T. Rowe Price hire employees to manage portfolios, Vanguard recruits outside freelancers known as subadvisers. Vanguard is the largest user of subadvisers, managing $350 billion with 30 outside firms.

Vanguard argues that because of its size and scale, the company can recruit the best subadvisers at cost-effective rates. Managers are typically paid fees that are less than 0.3% of assets, a percentage level that is well below industry averages.

The managers accept the modest compensation rates because they know that Vanguard subadvisers can generate rich income by overseeing huge portfolios. Another attraction is that Vanguard is a famously loyal employer, keeping the average subadviser for 13 years. If a subadviser delivers disappointing results for a couple of years, Vanguard does not fire the poor performer immediately. Instead, the company waits patiently for a recovery.

As an additional incentive, Vanguard pays performance-based fees. Under this system, managers who outdo their benchmarks receive extra payments. Those who underperform see their compensation reduced. Most managers hate performance fees, and only 3% of mutual funds use them. But Vanguard argues that the performance fees have been important factors in its success.

In its study, Vanguard repeats the boilerplate that past performance does not guarantee future success. Still, there are good reasons to believe that the company's effective system will continue providing actively managed funds that outdo the benchmarks.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.